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The thing about flat stock markets

Jul 30, 2015

You might have looked at your last brokerage statement and wondered why you’re no longer seeing the asset balance increasing like it had been. You may have taken a glance at your 401(k) the other day and wondered why it’s barely budged since Thanksgiving, excluding the contributions you’ve been making every two weeks.

You’re not crazy. The U.S. stock market has essentially gone nowhere in over 120 days. For every area of the market reaching new heights—think healthcare, software, and consumer discretionary—there’s one that’s been dragging the major averages back to the flatline; energy, materials, and industrial stocks, for example.

There’s a litany of reasons why the impossible rally that began in the fall of 2011 has hit a wall.

One could point to the (quite possibly) imminent start of an interest rate hike cycle along with the current plunge in commodity prices. We could also cite the slow but undeniable rise in employment costs, which threatens profit margins at such bellwether companies as Wal-Mart and McDonald’s.

Then there’s the fact that corporate earnings have stopped growing, putting the pressure on companies to keep up a continued expansion of price-earnings multiples for which there is zero justification. Bulls point out that, if you take energy stocks out of the S&P 500, earnings growth overall looks pretty decent. That’s great; and if we took Jar-Jar Binks out of Star Wars: The Phantom Menace and edited out all the stuff with the six-year-old kid, it’s a decent movie. But we can’t. The Phantom Menace was an atrocity and S&P 500 earnings have now gone, shall we say, ex-growth.

S&P 500 cumulative performance <br>since Jan. 2, 2015

And so, in the absence of a robust economy, and in the face of a potentially less accommodating Federal Reserve and peaking corporate profits, we go nowhere. The treadmill continues on as fewer stocks participate in each successive challenge to beat the S&P 500’s all-time record high. Only a handful of stocks and sectors are delivering uptrends on their own. The 52-week low list swells and the percentage of stocks below their 200-day moving average begins to resemble a highway pile-up at rush hour.

Market watchers have noted that the trading range (difference between the market’s highs and lows) so far in 2015 is among the narrowest ever recorded. The fact that this sort of mass indecision is transpiring just a few percentage points away from record highs is a fascinating development and possibly presages a major turning point in the predominant trend.

Put simply, we’re running out of both breadth and breath.

The important thing to remember, however, is that flat markets are not necessarily predictive of what will happen in the immediate future. I took a look at the historical record to get a sense of what happens when the S&P 500 finishes the first seven months of the year flat. There were some genuine surprises in the data.

There have only been 12 years since 1926 in which the S&P 500 was trading between up or down 2% through the end of July. That’s roughly 13% of the time in a 90-year sample set. So, the first observation we should make is that a flat market this late in the year is relatively rare.

When we think of a flat market, we think of choppiness, but volatility has actually been muted during the years in question. Looking at standard deviation, it turns out that the average volatility of these 12 flat years was substantially lower than the volatility of a typical year in the stock market. The flat years featured standard deviations of just 11.5% versus almost 19% for a typical year.

“But Josh”, you may be asking, “what happens next?”

If I knew the answer to that, I’d be halfway to my own private Aegean Island with the cast of Taylor Swift’s ‘Bad Blood’ video and a 10-gallon drum of ranch dressing (don’t ask).

Unfortunately, I don’t have a concrete answer. Fortunately, I’m not completely useless. I come armed with a range of outcomes worth considering based on how flat markets have resolved throughout history.

Let’s start with the worst case scenario on record, the flat market through July 1930 that ended up horribly to the downside, an August to December plunge of 28.5%. It happened, no sense in denying that it’s possible. But, and this is a major but, please bear in mind that this was right after the Crash of 1929 and 1930 was the year that ushered in the Great Depression.

When we look at the next two worst outcomes, we see how much of an outlier 1930’s resolution was. In 1941, the S&P dropped by 17.5% in the last five months of the year, punctuated by the events at Pearl Harbor in December. In 1990, another recession year, the S&P fell out of the flatline and finished down by 6% as America fought through the first Gulf War and the Savings & Loans Crisis put a dent in the economy.

In only one instance of our 12 years, 1994, did we see the year end unchanged. By the end of 1994, the stock market closed down 1.5% as markets recovered from the shock of Alan Greenspan’s surprise summer rate hike.

But that’s it for the losses. The S&P 500 declined in only three of the years of our sample and was flat in one. In the other eight years, investors were rewarded—in some cases, very handsomely. In 1942, 1949, and 2010, the S&P 500 delivered returns of between 9% and 13% once the stalemate of the first seven months was broken.

The median return for all 12 flat-market years has been 6%. This is about half of the median return for all years since 1926, but it’s not exactly chopped liver. And remember, this is against the backdrop of substantially lower volatility, on average.

Flat markets do not necessarily suggest any particular outcome when the S&P 500 finally breaks out of its slumber. It’s been down three times, flat once, and markedly higher in the other eight instances. All those narratives on what’s about to happen based on the current trading range should be discounted or ignored with extreme prejudice. The most common resolution has been a gain with much less volatility than usual, but the outcomes have been all over the map.

Keep this grain of salt handy for the next time someone tells you otherwise.

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